Men and women often determine whether to purchase a stock based simply on its share price. They make the assumption that a low price means the stock is cheap, while one with a higher price tag is expensive. As a result, they make decisions that end up hurting them in the long run.
Penny stocks, or those that are cheapest, typically come with the most risk. A stock with a high price tag now or one that is decreasing rapidly may end up with no value, while one that just doubled might double again in the very near future. The only way to truly determine whether a stock should be purchased is to look at multiple factors.
Price Does Not Equal Value
Investors tend to make decisions believing the value of the stock is determined by the price. However, there is a key difference between the price and the value. The price at any given time only provides information about the current or market value of that company and how much the stock is currently trading at. This is a price that both the buyer and seller have agreed upon, and more buyers mean the price is rising. In contrast, when more people are choosing to sell that stock as opposed to buying it, the price decreases.
The actual value of the company, however, is determined by its intrinsic value. Tangible and intangible factors are used to determine this value, including fundamental analysis. For example, when figuring out the value of a company, investors need to consider the company’s financial statements, its business model, and much more. Both quantitative and qualitative factors need to be assessed during this process to obtain an accurate picture of the company’s intrinsic value.
When Should Price Be a Consideration?
Share price does have an impact on a company. Not only are there psychological implications when one is dealing with the stock market, but there are also real implications that may have an impact on a company’s solvency. When a company needs to bring in additional funds, they do so either by taking on debt or through equity.
A weighted average of an organization’s cost of equity and cost of debt is known as their WACC or weighted average cost of capital. When the firm’s share price drops significantly, the cost of equity increases. As a result, the WACC climbs. When this happens, a business might find it cannot continue to operate, especially when it is capital-dependent. Investors need to bear this in mind when a stock sharply declines.
Why Investors Buy or Sell Based on Price
When it comes to the stock market, the most visibly quoted figure remains the price. The problem is that all factors must be taken into consideration when trading. Two companies may have very different market capitalization figures and shares available for sale, but the stock price is the same. The market capitalization figure provides the investor with information about the total market value of all shares available for purchase. The companies are very different in terms of their overall values, but investors won’t know this if they only look at the stock price.
Furthermore, when looking at the price, investors only consider how much they will spend to obtain one share. As a result, they may go with those shares that come with a lower price tag. What they really need to be determining is whether one stock is significantly overvalued and that is why it comes with a low price tag while another has a high price tag but is actually undervalued. This is why it is so important to research companies before making a purchase. Market capitalization provides the investor with a better look at how the company is valued, so the person purchasing the shares can truly assess their worth.
Share Price and Market Capitalization
Shares offer investors a means of tracking the units they have in a company and are nothing more than stocks that have been divided up to create these shares. The investor obtains a portion of the company when they purchase shares and this portion corresponds to a portion of the total shares. Publicly listed companies, however, vary greatly in terms of the actual number of shares outstanding.
Stock splits and reverse stock splits allow companies to retain control over the number of available shares and investor feelings about the share price. Stock prices come with psychological associations, and companies benefit from this. For instance, investors typically choose to buy stocks 100 at a time. As a result, many people won’t buy stocks with a share price of $100 because they would have to turn over $10,000 at one time to purchase this quantity of shares. To avoid this, companies might opt to do a two-for-one stock split.
What Is a Stock Split and How Does It Work?
With a two-for-one stock split, the company offering the stock agrees to change every single share of stock into two. When this happens, the value of each share is divided in half, and the new shares created by the split have the same value as the original share. This benefits the investor who feels more comfortable spending less while still getting the same number of stocks. However, the transactions are equal in the end.
With the split, the investor still ends up with the same percentage ownership. This is where market capitalization comes into play. The company’s market cap isn’t affected by the split, so the figures remain the same although they look different on paper.
Reverse Split
In contrast, reverse splits serve as the opposite of stock splits and come with their own psychological associations. Investors may avoid low-cost stocks assuming they are riskier than those with a higher price tag. To counteract this, a company might choose to offer a one-for-two reverse stock split.
In this type of scenario, a company carries out a one-for-two stock split when its share price drops below a certain amount. By doing so, it doesn’t add value to the stock or have an impact on the risk associated with the purchase. It simply alters the share price to encourage investors to buy.
Berkshire Hathaway and Microsoft
Berkshire Hathaway and Microsoft have made use of stock restructuring to encourage investors to purchase shares in their company. However, both have generated outstanding shareholder value. The way they did so is where they differ. Microsoft accomplished this by splitting several times, but Berkshire opted not to split. This is why investors need to consider the underlying fundamentals as opposed to making decisions based solely on share price.
Additional Factors to Be Considered
Other factors need to be taken into consideration when determining whether a particular stock should be purchased. Following are some factors an investor should look at when making this determination.
Financial Health
Always take the time to examine a company’s financial health as this could have an impact on the stock price. When looking at the market, investors see stocks with a strong track record tend to be offered by those companies with robust financial statements and solid earnings. If combined with the stock price, these figures provide the investor with a better understanding of whether the company is financially healthy or if problems could be on the horizon. Stock prices often fluctuate based on investors and their feelings about the company’s financial future, so keep this in mind when choosing which stocks are a good buy and which are to be avoided.
Company News
Furthermore, investors need to take the time to read news about the company. This may come in the form of a news report about the company’s positive earnings, or it might be a press release announcing the launch of a new product or the expansion of the company into a new area. Economic data should also be considered at this time, as items such as the monthly jobs report, can have a positive impact on a company’s share prices.
However, when the news reports are negative, investors need to consider whether they wish to put their money in this stock, as negative reports can lead to the share price decreasing. The investor then needs to determine if now is the time to purchase the stock or if it would be wiser to wait and see if the price drops even more. If it does, the investor then needs to decide if buying would be smart or if other stocks need to be considered.
Never focus solely on the share price when choosing which stocks to invest in. Although the price should be factored into the decision-making process, it is only one element. Additionally, companies can affect the stock price using a variety of techniques, such as a reverse split or stock split. Investors need to be aware of this and take into account any share events that occurred manipulations during this process.
The key to successful investing lies in researching potential purchases. High-priced stocks can increase in both price and value, and cheap stocks may go even lower if the stock isn’t a good value. For this reason, investors need to carefully consider where to put their money as well as which broker to use for the process. By doing so, a person can feel more confident investing their hard-earned funds.